Chapter 18

Market Failures

TRANSACTION COSTS: BARTER, MARRIAGE, AND
MONEY

So far, I have generally assumed that if there is
a possibility for a trade--if I am willing to sell something at a
price at which you are willing to buy it--the trade occurs. I have
ignored both the problems of finding a trading partner and
negotiating a trade and the associated transaction costs.

Barter vs Money

The simplest form of trade is barter; I trade
goods that I have and you want for goods that you have and I want.
This raises a problem. I must find a trading partner who has what I
want and wants what I have: what economists call a double
coincidence of wants. In a simple society in which there are only
a few goods being traded, this may not be a serious problem; but in a
complicated society such as ours, it is. If I want to buy a car, I
first look in the classified ads to find someone who is selling the
kind of car I want, then call him up and ask him if he wants to be
taught economics in exchange for his car. This drastically reduces
the number of potential trading partners.

The solution is the development of money--some
good that almost everyone is willing to accept in exchange. Money
usually starts out as some good (gold, cloth, cattle--the word
"pecuniary" comes from the Latin word for cattle) valued for its own
uses; people are willing to accept it even if they do not intend to
consume it, because they know they can later exchange it for
something else. In a money economy, I find one person who wants what
I have, sell it to him, and then use the money to buy what I want
from someone else.

The advantage of money is obvious; the
disadvantage is that you cannot eat it or wear it (exception:
wadmal, wool cloth used as money in medieval Iceland). If
markets are thin--if there are few people buying or
selling--the individual who chooses to hold a stock of money may find
that he cannot easily exchange it for what he needs when he needs
it.

Thin markets cause two different problems for
someone who wants to buy or sell. The first is that there may be
nobody who wants what he is selling today or is selling what he wants
to buy; the mere process of locating a trading partner may be
expensive and time consuming. The second is that if he does find a
trading partner, he becomes part of a bilateral monopoly--one buyer,
one seller. Bilateral monopoly, for reasons discussed in an earlier
chapter, can lead to substantial transaction costs: time and
energy spent haggling over the price, and deals that do not get made
because of a breakdown in bargaining.

In a society in which markets are thin and the
number of traded commodities is small enough so that the double
coincidence problem is not too serious, individuals may find it more
convenient to hold wealth in the form of goods rather than money.
This was probably the situation in early medieval Europe. Coins
existed and were used in exchange; but barter was, for several
centuries, more common.

A Market We All Know and
Love

In order to understand the difficulties of barter,
it is useful to consider the large-scale barter market of which you
are all part--the marriage/dating/sex market. The reason this is a
barter market is that if I am going out with or married to you, you
are necessarily going out with or married to me. I must find a woman
whom I want and who wants me--the double coincidence of
wants.

We observe, in this market, large search costs,
long search times, lots of frustrated and/or lonely people of both
sexes--in other words, a market where traders have a hard time
getting together, due largely to the high transaction costs of
barter.

PUBLIC GOODS AND
EXTERNALITIES

In Chapter 1, I pointed out that even if every
individual in a group behaves rationally, the result may be
undesirable--for every individual. This happens when one person's
actions impose costs or benefits on others. The examples I gave in
Chapter 1 involved students cutting across the lawn and fighters
running away in battle, shooting their weapons without aiming them,
or not shooting at all. In such situations, the rationality of the
individual does not imply that the group acts as if it were
rational.

The rest of this chapter will be devoted to a
discussion of situations of this sort. I will start with a number of
specific examples and then go on to explain the two general
categories under which many such problems are usually classed in
economics: public goods and externalities. I will end by discussing
the special problems associated with imperfect
information.

Good for Each May Not Be Good for All:
Some Examples

I will give three examples of conflicts between
the individual rationality of the members of a group and their
welfare. Two--the first and the last--are situations that should be
familiar to every reader over the age of 17. The other is a widely
discussed public policy issue with which I hope most of you have had
no personal experience.

To Vote or Not to Vote? In deciding whether
to vote in the next election, one should consider both costs and
benefits. The costs are fairly obvious: a certain amount of time
standing in line and additional time spent studying issues and
candidates in order to decide how to vote. The benefits are of two
sorts: those that do not depend on the effect of your vote on the
election, and those that do. An example of the first sort might be
your feeling of having done your civic duty or your pleasure at
voting against a candidate you particularly dislike.

The second sort of benefit comes from the effect
of your vote on the outcome of the election. In evaluating such
benefits, you should consider two questions: how important it is that
the right candidate win and how likely it is that your vote will
affect the outcome. In most large elections, the probability that
your vote will affect the outcome is very small; in a presidential
election, it is well under one in a million. Unless getting the right
person elected is immensely valuable to you--so valuable that you are
willing to bear the costs of voting in exchange for one chance in a
million of influencing the outcome--the effect of your vote on the
election is not a good reason for voting unless you expect the
election to be extraordinarily close. If you vote anyway--because you
enjoy voting or because you believe that good citizens vote or
because you like being part of a history-making event reported on
nationwide television--the minuscule effect of your vote on the
election gives you very little incentive to be sure you are voting
for the best candidate.

The usual response to arguments of this sort is
either "You are saying people should be selfish" or "What if everyone
did that?" The answer to the first is that I have not assumed that
you are selfish in any conventional sense of the word. I assume you
are concerned with costs and benefits, but I include as a benefit the
achieving of whatever objectives you happen to have. Obviously
individuals have objectives that are not selfish in any narrow
sense--they value the welfare of their children, their friends, and
(to a lesser degree) people they do not even know. One reason you
might put a high value on electing the right candidate is the belief
that doing so will benefit not only yourself but hundreds of millions
of other people. If you were so altruistic as to give the same weight
to the welfare of every other person as to your own, then the benefit
of electing the right candidate would be hundreds of millions of
times as great as the direct benefit to you. That might be a
sufficient reason to spend an hour or two voting, even if you
realized that all you were buying was one chance in a million of
influencing the outcome of the election. Casual observation suggests
that few people are that altruistic.

The question "What if everybody acted like that?"
can be answered in two ways. The first is to point out that if enough
people refrained from voting, the remaining voters would each have a
substantial chance of influencing the outcome of the election, and it
would then pay them to vote. The equilibrium would be a situation in
which the (say) ten thousand most concerned citizens
voted.

The second answer to the question "What if
everybody acted like that?" is to point out that the question
implicitly assumes that true beliefs must have desirable
consequences--and therefore that beliefs with undesirable
consequences must be false. There is no reason why this must always
be so. Perhaps it is true both that sensible people will not vote and
that if everyone acts on that principle the consequences will be bad.
If so, it might be wise for me not to tell you that sensible people
do not vote, but that does not make it untrue. A statement may be
both true and dangerous. The previous sentence is such a
statement--since it provides ammunition for those who wish to argue
against free speech.

The apparent paradox--that if everyone correctly
perceives how to act in his own interest and does so, everyone may be
worse off as a result--comes from the fact that different people have
different objectives. Suppose there are a hundred of us, each of whom
can individually choose action A or action B. My taking action A
gives me $10 and costs the rest of you a total of $20. Your taking
action A gives you $10 and costs the rest of us, including me, a
total of $20. As long as we act separately, it is in the interest of
each of us to take action A--making us all worse off than if we had
all taken action B. The problem is that I only control my action--and
I am better off taking A than B. This, of course, is the problem we
encountered long ago in the discussion of why soldiers run
away.

A simple and striking example of such a situation
is the prisoner's dilemma discussed back in Chapter 11. Joe and Mike,
the two accused criminals, would both be better off if they both kept
silent. But if Mike confesses, the D.A. will have the evidence needed
to convict Joe--and will punish him for his silence with a stiff
sentence. So if Mike is going to confess, Joe had better confess too.
If Mike stays silent and Joe confesses, the D.A. will express his
gratitude by letting Joe off with a token sentence. So if Mike is not
going to confess, Joe is better off confessing. Whatever Mike does,
Joe is better off confessing, and similarly for Mike. They both
confess, and both get worse sentences than if they had both kept
silent.

Plea Bargaining:
A Real-World Prisoner's Dilemma. A plea bargain is an arrangement
by which a prosecutor, instead of trying a defendant on a charge of,
say, first-degree murder, allows the defendant to plead guilty to a
lesser charge, such as second-degree murder or manslaughter. It is
widely criticized as a way of letting criminals off lightly. In fact,
it seems likely that the existence of plea bargaining results in
criminals being punished more severely rather than less. If plea
bargaining were abolished--as some people suggest it should be--the
result might well be to reduce the sentence received by the average
criminal.

How can this be? Surely a criminal will only plead
guilty to the lesser charge if doing so is in his interest--which
means that a certain conviction on the less serious charge is
preferable, for him, to whatever he believes the chance is of being
convicted on the more serious charge. True. But the chance of a
conviction depends on what resources, of money and time, the
prosecution spends on that particular case--which in turn depends on
how many other cases had to go to trial and how many were settled by
plea bargaining.

Suppose there are 100 cases per year, and the
district attorney has a budget of $100,000. He can only spend $1,000
on each case, with the result that 50 percent of the criminals are
acquitted. With plea bargaining, the D.A. concentrates his resources
on the ten criminals who refuse to accept the bargain he offers. He
spends $10,000 prosecuting each of them and gets a conviction rate of
90 percent. Each criminal deciding whether to accept the D.A.'s offer
knows that, if he refuses, he has about a 90 percent chance of being
convicted--so he accepts any offer that he prefers to a 90 percent
chance of conviction. On average, all the criminals, both the ones
who accept the bargain and the ones who do not, are worse off--more
severely punished--than if the D. A. prosecuted all of them on the
more severe charge and convicted half. Each individual criminal
benefits by accepting the D.A.'s offer--but by doing so, he frees
resources that the D.A. can then use against another criminal,
raising the average conviction rate. The higher conviction rate makes
criminals willing to accept worse bargains. All of the criminals
would be better off if none of them accepted the D.A.'s offer, but
each is better off accepting. This is the prisoner's dilemma in real
life.

Why Traffic Jams. This is a situation in
which each individual takes the action that is in his individual
interest; they are all, as a result, worse off than if they had acted
differently. A more familiar example of such a situation occurs twice
a day, five days a week, about two blocks from where I used to live.
The time is rush hour; the scene is the intersection of Wilshire
Boulevard and Westwood Avenue in Los Angeles, said to be the busiest
intersection in the world. As the light on Wilshire goes green, ten
lanes of traffic surge forward. As it turns yellow, a last few cars
try to make it across. Since Wilshire is packed with cars, they fail
and end up in the intersection, blocking the cars on Westwood, which
now have a green light. Gradually the cars in the intersection make
it across, allowing the traffic on Westwood to surge forward--just as
the light changes, trapping another batch of cars in the
intersection.

If drivers on both streets refrained from entering
the intersection until there was clearly enough room for them on the
far side, the jam would not occur. Traffic would flow faster, and
they would all get where they are going sooner. Yet each individual
driver is behaving rationally. My aggressive driving on Wilshire
benefits me (I may make it across before the light changes, and at
worst I will get far enough into the intersection not to be blocked
by cars going the other way at the next stage of the jam) and harms
drivers on Westwood. Your aggressive driving on Westwood benefits you
and harms drivers (possibly including me) on Wilshire. The harm is
much larger than the benefit, so on net we are all worse off. But I
receive all of the benefit and none of the harm from the particular
decision that I control. I am correctly choosing the action that best
achieves my objectives--but if we each made a mistake and drove less
aggressively, we would all be better off.

My point, in this and the previous examples, is
not that rationality implies selfishness. That is a parody of
economics. Drivers may value other people's time as well as (although
probably not as much as) their own. In Chapter 21, we will discuss
the economics of altruism--the behavior of people who value
the happiness of other people. If drivers value the welfare of other
drivers, rationality may prevent the jam instead of causing
it.

The point--which to some readers may seem
paradoxical--is that rational behavior by every individual in a group
may sometimes lead to an outcome that is undesirable in terms of
precisely the same objectives (getting home earlier in this case or
getting a light sentence or surviving a battle in some of the other
cases we have discussed) that each individual's rational behavior is
correctly calculated to achieve. Such situations often involve what
economists call public goods or externalities, two concepts that we
will now discuss.

Public Goods

There are a number of different, closely related
definitions of a public good. I prefer to define it as "a
good such that, if it is produced at all, the producer cannot control
who gets it." The public-good problem arises because the
producer of a public good cannot, like the producer of an ordinary
("private") good, tell the consumer that he can only have it if he
pays for it; the consumer knows that if it is produced at all, the
producer has no control over who gets it.

One example of a public good is a radio broadcast;
if it is made at all, anyone who owns a radio and lives in the right
area can receive it. This example demonstrates several important
things about public goods. The first is that whether or not a good is
public depends on the nature of the good. It is not that the producer
should not control who gets it but that he cannot; or,
at least, he can control who gets it, if at all, only at a
prohibitively high cost (hiring detectives to creep around people's
houses and arrest them if they are listening to the broadcast without
having paid for it). While the publicness of a good may be affected
by the legal system (whether it is legal to listen to a broadcast
without the broadcaster's permission), it is mostly just a fact of
nature; even if it were legal to forbid unauthorized listening, the
law would be prohibitively expensive to enforce.

A second important thing to note about a public
good is that it is not defined as a good produced by the
government. In this country, radio broadcasts are mostly private;
they are still public goods. Many of the things government does
produce, such as mail delivery, are private goods; the government can
and does refuse to deliver your letter if it does not have a stamp on
it. The fact that a good is public presents a problem to a private
producer--the problem of how to get paid for producing it--but the
problem is not necessarily an insoluble one, as the example of a
radio broadcast illustrates.

Private Production of Public Goods. There
are a number of ways in which the problem of producing public goods
privately may be solved. One, which works best if the size of the
public (the group of people who will receive the good if it is
produced) is small, is a unanimous contract. The producer gets all
the members of the public together, tells them how much he wants each
to pay toward the cost of producing the good, and announces that
unless each agrees to chip in if everyone else does, the good will
not be produced.

Assume that they believe him. Consider the logic
of the situation from the standpoint of a single member of the group
deciding whether he should agree to chip in. He reasons as
follows:

Either someone else is going to refuse, in which
case the deal falls through, I get my money back, and my agreement
costs me nothing, or else everyone else is going to agree. If
everyone else agrees and I refuse, I do not have to pay for the
public good, but I also do not get it. So as long as the good is
worth more to me than my share of the cost, I ought to
agree.

The same argument applies to everyone, so if the
public good is worth more to the consumers than it costs to produce,
the entrepreneur should be able to divide up the cost in such a way
that each individual finds it in his interest to agree.

One difficulty with this is that if the public is
large, it may be hard to organize a unanimous contract. One solution
is to find a privileged minority: a subgroup of the public
that is small enough so that its members can form their own unanimous
contract and that receives enough benefit from the public good so
that its members can be persuaded to bear the whole cost. When I mow
my front lawn, I am acting as a privileged minority (of one); the
mowed lawn makes the neighborhood more attractive, benefiting
everyone, but I receive enough of the benefit to be willing to pay
the whole cost.

Consider how this might work in the case of one of
the largest public goods in our society and one of the most difficult
to produce privately: national defense. Suppose the inhabitants of
Hawaii believe that there is a 10 percent chance of a nuclear strike
against their island next year. If the strike occurs, the island will
be wiped out. The inhabitants can flee the island before the attack,
so the cost will be distributed roughly in proportion to the value of
the land they own. Table 18-1 is an (entirely imaginary) listing of
how land ownership is divided on the island and how much each owner
would pay, if necessary, to prevent the attack.

Table 18-1

Landowner

Value of Land

Value of Defense

Dole Pineapple

$400,000,000

40,000,000

Hilton Hotels

$400,000,000

40,000,000

United Fruite Co.

$300,000,000

$30,000,000

Maxwell House Coffee

$250,000,000

$25,000,000

Howard Johnson's

$200,000,000

$10,000,000

Everyone Else

$900,000,000

$90,000,000

Suppose an entrepreneur comes up with a system for defending Hawaii
from nuclear attack at a cost of $100 million. He goes to Dole,
Hilton, United Fruit, and Maxwell House and tells them that if they
pay him $110 million, he will defend the island. Since the value to
them of the defense is more than that and since there are only a few
firms that have to agree, they raise the money.

In this case, the story has a happy ending.
Suppose, however, that the total cost of the defense is $149 million.
It is still worth having--the top five landowners alone value it at
more than its cost--but it will be very hard to get. If the
entrepreneur asks the Big 5 to each put up the same proportion of the
value of their land (just under 10 percent), Howard Johnson will
refuse. Unfortunately for Hawaii, the Howard Johnson firm is run by
an optimist who believes the chance of an attack is only 5 percent
and therefore is willing to pay only 5 percent of his land value to
protect against the attack.

If the information on Table 18-1 were a matter of
public knowledge, agreement could still be reached, with Howard
Johnson contributing at half the rate of the other four. The problem
is that the other contributors are likely to view Howard Johnson's
optimism as a bargaining ploy, a way to get them to pay more than
their share of the cost. If there is no simple rule for dividing up
the cost of defense, agreement on who pays what may well be
impossible.

The larger the number of people whose agreement is
needed and the less obvious it is how much each values what he is
getting, the harder it will be to get agreement. If the public good
is cheap--if defense costs only $40 million--the problem is soluble;
the entrepreneur can either leave Howard Johnson out of the contract
or else charge everyone 5 percent of land value and still raise
enough money. But if the cost of the public good is a large fraction
of the benefit it produces and if the benefit is spread among many
people, raising the money is a serious and perhaps insoluble
problem.

In the example discussed, the concentration of
land ownership in Hawaii greatly simplified the situation. The Big 5
were a privileged minority; they received a large fraction of the
total benefit, so the entrepreneur could, with luck, raise the money
he needed from them while ignoring the large number of small holders.
The term "privileged minority," which is commonly used in this way,
has always struck me as somewhat strange, since the minority has the
"privilege" of paying for what all the other members of the public
get for free.

Unanimous contracts are one solution to the
problem of producing a public good. Another solution is to convert
the public good temporarily into a private good. Suppose the public
good is flood control; building a dam will reduce floods in the
valley below, increasing the value of farm land there. One way to pay
for the dam is for the entrepreneur to buy up as much as possible of
the land in the valley (or buy options on the land at its current
price), build the dam, then sell the land back (or sell the options
back to the owners). Since the new flood protection makes the land
worth more than when he bought it, he should be able to get a higher
price than he paid, for either the land or the options.

Another ingenious solution, which would never have
occurred to me if I had not seen it in operation, is to combine two
public goods and give away the package. The first public good has a
positive cost of production and a positive value to the customer; the
second has a negative cost of production and a negative value to the
customer. The package has zero or negative cost of production and
positive value to the consumer.

This is how radio and television broadcasts are
produced; the first good is the program and the second the
commercial. Commercials have a negative cost of production from the
standpoint of the broadcaster; he gets paid by the sponsor to
broadcast them. Since there is usually no convenient way to listen to
the program without hearing the commercials, the listener must choose
to accept or reject a package deal--program plus commercial. If the
net value of the package is positive to him, he will accept it. If
the net cost (cost of operating the station minus payment from the
sponsor) is negative, if advertising revenues more than cover
operating expenses, the broadcaster can and will stay in
business.

An interesting example of the public-good problem,
and several interesting solutions, occur in the computer industry. A
$300 computer program can be copied onto a $3 floppy disk. Programs
can be protected against copying, but this is inconvenient for the
user, who would like at least one backup copy in case his original
gets damaged and who may also find it convenient to copy several of
the programs he has purchased onto one disk. Even if programs are
protected, someone with a reasonable amount of expertise can
frequently "break" the protection--figure out how to copy them. There
are even programs on the market designed to copy copy-protected
programs. In one case, a program capable of copying other
copy-protected programs was copy-protected against itself; a second
company sold a program to copy it!

If you cannot effectively copy-protect a program,
selling it to one person means, in effect, giving it to everyone. The
program is then a public good and figuring out how to make money
producing it is a public-good problem. Firms that produce and sell
software have come up with a number of ingenious solutions. One of
them is bundling. You sell a computer along with a bundle of
programs designed to run on that particular computer; in effect you
charge for the programs in the price of the computer. Anyone can copy
the programs--but to use them, he has to buy the computer. Another
kind of bundling is to sell a package consisting of a program plus
service: a voice on the other end of a telephone to answer questions
about how to make the program work. The seller keeps track of who
bought the program and only gives help to registered owners. A third
kind of bundling is exemplified by the way in which I "sell" the
computer programs that go with this book. A professor who adopts the
book is given a free copy of the programs and permission to make
copies for his students. I get paid for my work writing the programs
in increased sales of the book. I hope.

As these examples suggest, there are a variety of
ways in which public goods can be privately produced. Each of these
may succeed, under some circumstances, in producing some quantity of
a public good. None of them can be relied on to lead to an efficient
level of production in the strong sense in which we have been using
the term--an outcome so good that it could not be improved by a
bureaucrat-god. Typically, the private producer of a public good
succeeds in collecting only part of the additional value of each unit
of the good produced. He produces up to the point where what he gets
for an additional unit (an additional hour of broadcasting, or an
additional dollar spent making the program better) is equal to what
it costs him. That is a lower level of output than the efficient
point where marginal cost to the producer equals marginal value to
the consumer.

To see more clearly the sense in which private
production of public goods is inefficient, consider some of our
examples. In the Hawaiian defense case, Hawaii was worth defending as
long as the cost was less than $245 million, since that was the total
value of the defense to all the inhabitants put together. If the cost
of the defense happened to be only $40 million, private arrangements
might produce it, which is the efficient outcome. If the cost were
$235 million, it is unlikely that the defense would be produced;
since it still costs less than its value, a bureaucrat-god who
ordered Hawaii defended would be producing a net benefit. So if the
cost of defending Hawaii is $235 million, private production results
in an inefficient outcome. Hawaii is worth defending--and is
undefended. The private production of public goods is inefficient in
the sense of sometimes leading to an inefficient outcome--failing to
produce a good that is worth producing.

We have assumed that there are only two possible
amounts of defense: none or enough. Whether or not that is plausible
in the case of defense, the equivalent assumption is obviously wrong
for radio broadcasts or computer programs; in each case, the
manufacturer decides how much he will spend and what quality of
product he will produce. The efficient outcome is one in which he
makes all quality improvements that are worth more to the consumers
than they cost him to make. But from his standpoint, improvements are
worth making only if they increase his revenue by at least as much as
they cost. Since he will be able to collect only part of the value he
produces, there may be improvements worth making that he does not
find it in his interest to make; so here again the outcome could be
improved by a bureaucrat-god. The good may be produced, but it is
generally underproduced: An increase in quality, number of hours of
broadcasting, or some other dimension would result in net benefits.
So private production of public goods is generally inefficient in the
technical sense in which I have been using the word.

The Efficient Quantity of a Public Good.
While we have talked about producing the efficient outcome, we have
not yet discussed how, in principle, one would find out what it is.
Figure 18-1 shows the answer to that question, for a very small
public. D1, D2, D3 are the demand
curves for radio broadcasting of three listeners. Each shows how much
broadcasting a listener would buy if it were an ordinary private
good--how many hours per day he would pay for as a function of the
price per hour. The figure assumes that number of hours per day of
broadcasting is the only relevant quality variable, the only way in
which the broadcaster can affect the value to his "customers" of what
he produces. MC shows the marginal cost curve faced by the
broadcaster--how much each additional hour per day of broadcasting
costs him.

Figure 18-1

Calculating the efficient quantity of a public
good. MV shows the total marginal value to the three
customers--the vertical sum of their demand curves. The efficient
quantity Q* is where MV=MC.

As usual, the efficient solution is to produce
where MV=MC--to keep increasing the number of hours as long as the
value of an additional hour to the listeners is at least as great as
its cost of production. We know from Chapter 4 that each demand curve
is also a marginal value curve. Each extra hour of broadcasting
benefits all three customers; its marginal value is the sum of its
marginal value to Customer 1, its marginal value to Customer 2, and
its marginal value to Customer 3. So the total MV curve is the
vertical sum of the MV curves for the customers, each of which equals
the corresponding demand curve. The result is shown on the figure. Q*
is the efficient quantity.

Public Production of Public Goods. One
obvious solution to the public-good problem is to have the government
produce the good and pay for it out of taxes. This may or may not be
an improvement on imperfect private production. The problem is that
the mechanism by which we try to make the government act in our
interest--voting--itself involves the private production of a public
good. As I pointed out earlier in this chapter, when you spend time
and energy deciding which candidate best serves the general interest
and then voting accordingly, most of the benefit of your expenditure
goes to other people. You are producing a public good: a vote for the
better candidate. That is a very hard public good to produce
privately, since the public is a very large one: the whole population
of the country. Hence it is underproduced--very much underproduced.
The underproduction of that public good means that people do not find
it in their interest to spend much effort deciding who is the best
candidate--which in turn means that democracy does not work very
well, so we cannot rely on the government to act in our
interest.

If we cannot rely on the government to act in our
interest, we cannot rely on it to produce the efficient quantity of
public goods. Just as with a government agency regulating a natural
monopoly, the administrators controlling the public production of a
public good may find that their own private interest, or the
political interest of the administration that appointed them, does
not lead them to maximize economic welfare.

Even if the government wishes to produce the
efficient amount of a public good, it faces problems similar to the
problems of regulators trying to satisfy the second efficiency
condition. In order to decide how much to produce, the government
must know how much potential consumers value the good. In an ordinary
market, the producer measures the demand curve by offering his
product at some price and seeing how many he sells. The producer of a
public good cannot do that, since he cannot control who gets the
good, so the government must find some indirect way of estimating
demand. Individuals who want the public good have an incentive, if
asked, to overstate how much they want it--which means that a public
opinion poll may produce a very poor estimate of demand.

In dealing with the public-good problem, just as
in dealing with the closely related problem of natural monopoly, we
are faced with a choice among different imperfect ways of solving the
problem, some private and some governmental. None of the alternatives
can be expected to generate an efficient result. As I pointed out
earlier, the fact that something is inefficient means that it could
be improved by a bureaucrat-god. That does not necessarily mean that
it can be improved by us, since we do not have any bureaucrat-gods
available.

As you may have realized by now, public-good
problems of one sort or another are very common--indeed many common
problems, both public and private, can be viewed as public-good
problems. One example is the problem of getting anything accomplished
in a meeting. Most of us like attention: When we are in a meeting and
happen to have the floor, we take the opportunity not only to say
what we have to say about the issue on hand but also to show how
clever, witty, and wise we are. This imposes a cost on other people
(unless we really are witty and wise); if there are sixty people in
the room, every minute I speak costs a person-hour of listener time.
Brevity, in this case, is a public good--and
underproduced.

At the beginning of this section, I mentioned that
different economists use slightly different definitions of a public
good. The definition I have used emphasizes non-excludability:
the inability of the producer to control which consumers get the
good. The other characteristic usually associated with a public good
is that one person's use does not reduce the amount available for
someone else. A different way of stating this is to say that the
marginal cost of producing the good is zero on the margin of how many
people get it, although there may still be a cost to producing more
on the margin of how much of it they get. Something that is a public
good in only this sense (it has zero marginal cost, but the producer
can control who gets it) is simply a natural monopoly with MC = 0.
Since the problems associated with natural monopoly have already been
discussed, I prefer to concentrate on the inability of the producer
to control who consumes the good, which seems to me to be the
essential characteristic of public goods responsible for the special
problems associated with them.

Externalities

The long-winded speaker is underproducing the
public good of brevity. Another, and equivalent, way of describing
the situation is to say that he is overproducing his speech. The
problem can be described either as underproduction due to the
public-good problem or as overproduction due to the existence of an
externality.

An externality is a net cost or benefit
that my action imposes on you. Familiar examples--in addition to the
cost of listening to me talk too long in a meeting--are pollution (a
negative externality--a cost) and scientific progress as a result of
theoretical research (a positive externality--a benefit).
Externalities are all around us: When I paint my house or mow my
lawn, I confer positive externalities on my neighbors; when you smoke
in a restaurant or play loud music in the dorm at 1:00 a.m., you
confer negative externalities on yours.

The problem with externalities is that since you,
rationally enough, do not take them into account in deciding whether
or not to smoke or play the music, you may do so even when the total
cost (including the cost to your neighbors) is greater than the total
benefit. Similarly, I may fail to mow my lawn this week because the
benefit to me is less than the cost, even though the total benefit
(including the benefit to my neighbors) is more.

As you can see by these examples, "externalities"
and "public goods" are really different ways of describing the same
problems. A positive externality is a public good; a negative
externality is a "negative" public good and refraining from producing
it is a positive public good. In some cases, it may be easier to look
at the problem one way, in some cases the other--but it is the same
problem.

Figure 18-2 is a graphical analysis of the
inefficiency due to an externality. D is the demand curve for steel.
S is the industry supply curve for the competitive industry that
produces steel. The industry produces a quantity Qs at a
price Ps.

In addition to the costs that the industry pays
for its inputs, there is another cost to producing steel: pollution.
For every ton of steel it produces, the industry also produces a
negative externality of $10. So the true marginal cost of a ton of
steel is $10 above the marginal private cost, the cost to the
industry, which is what determines the industry's supply curve. S' is
what the supply curve would be if the industry included in its
calculations the cost of the pollution it produced. The efficient
level of output is where marginal cost equals marginal value--where
S' intersects D at a quantity of Qs'. From the standpoint
of efficiency, the situation is exactly as if the supply curve were
S' but the industry, for some reason, produced Qs. The
resulting inefficiency is the colored area A on the figure. The
society as a whole--producers, consumers, and victims of
pollution--is that much worse off than if the firms produced the
efficient quantity Qs'.

So far we have assumed that the only way of
reducing pollution is to reduce the amount of steel produced. There
may be other alternatives. By filtering its smokestacks or using low
sulfur coal, the firm may be able to eliminate a dollar's worth of
pollution at a cost of less than a dollar.

Supply and demand for steel.
(Qs, Ps) is the uncontrolled equilibrium. S' is
what the supply curve would be if the steel firms included in their
cost calculations the cost ($10/ton) that their pollution imposes on
others. S'' is what it would be if the firms included pollution cost,
but reduced it by purchasing the efficient level of pollution
control, as shown on Figure 18-3.

Figure 18-3 shows that possibility. For
simplicity, I assume that the cost for a given reduction of pollution
per ton is proportional to the amount of steel the firm is producing.
TC is the total cost function for producing pollution control. It
shows how many dollars must be spent on pollution control per ton of
steel produced in order to reduce pollution per ton to any particular
level. MC is the corresponding marginal cost function, showing the
cost of the additional pollution control required to eliminate an
additional dollar's worth of pollution.

As we already know, the efficient quantity of
output occurs where marginal cost equals marginal value. The value of
eliminating $5 worth of pollution is $5; marginal value is $1 per
dollar. The steel firm should keep increasing its expenditure on
pollution control until the last dollar buys exactly a dollar's worth
of pollution control. The efficient amount of pollution per ton is at
Qp, where MC crosses MV.

Cost curves for controlling pollution. TC shows total cost/ton
of steel for reducing pollution as a function of the amount of
pollution produced. MC is the corresponding marginal cost, MV the
marginal value of pollution control.

If steel firms install the efficient level of
pollution control, they will spend $2.50/ton on pollution control and
produce $4.50/ton worth of pollution. The cost of producing steel,
including the cost to the producers of controlling pollution and the
cost to everyone else of the pollution they do not control, is $7/ton
higher than the cost to the firms of producing steel with no
pollution control. The corresponding supply curve is S'' on Figure
18-2. The efficient quantity of steel is Qs''.

What is the efficiency loss from producing
Qs without pollution control instead of Qs''
with pollution control? Producing Qs without pollution
control instead of Qs' without pollution control costs
area A. Producing Qs' without pollution control instead of
Qs'' with pollution control raises the supply curve from
S'' to S' and moves quantity from Qs'' to Qs',
so it costs the shaded area B, the resulting change in total surplus.
Going from S' and Qs to S' and Qs' saves area
A; going from there to S'' and Qs'' saves an additional
area B; so the net savings in moving from the initial inefficient
outcome to the final efficient one is A+B. That is the inefficiency
of the uncontrolled outcome, compared to the outcome that would be
chosen by a bureaucrat-god.

Efficient
Pollution and How to Get It: The Public Solution. The textbook
solution to externalities is to impose the cost on, or give the
benefit to, the producer. If I am benefiting others by scientific
research, subsidize me; if I am polluting the air, charge me an
effluent fee of so many dollars per cubic foot of pollution
emitted, corresponding to the costs that my pollution imposes on
others. I will continue to pollute only if the net value of what I am
doing is more than the damage done--in which case, pollution is
efficient. If each steel firm must pay an effluent fee of $1 for each
dollar's worth of pollution it produces, the supply curve for steel
will shift to S'' and the quantity produced will be Qs''.
The industry will produce an efficient amount of steel--and an
efficient amount of pollution.

"Pollution" is a loaded word. To be in favor of
pollution sounds like being in favor of evil; the phrase "an
efficient level of pollution," lifted from a book like this one,
would be fine ammunition for a speech on the inhumanity of
economics--and economists.

If you find the idea that some amount of pollution
is desirable a shocking one, consider that carbon dioxide is commonly
regarded as a pollutant, and the only way you can stop producing it
is to stop breathing. This is an extreme case, but it makes an
important point--that the real issue is whether, in any particular
case, the costs of pollution are greater than the costs of not
polluting.

While there is, in this sense, an efficient level
of pollution, it is not clear how to get that level. The problem with
using effluent fees to control externalities is the same as the
problem with government provision of public goods; it depends on the
government finding it in its interest to act in the interest of the
public and knowing how to do so. Just as in previous cases, "knowing
how" includes somehow estimating the value of something to people by
some method other than offering it at a price and seeing whether they
take it. The result of the governmental solution may be better or
worse than the alternatives of either accepting the overproduction of
negative externalities and the underproduction of positive ones, or
dealing with the problem in some imperfect private way.

Private Solutions. How might one control
externalities privately? One (real-world) solution is a proprietary
community. A developer builds a housing development and sells the
houses with the requirement that the buyer must join the neighborhood
association. The neighborhood association either takes care of lawns,
painting, and other things that affect the general appearance of the
community or requires the owners to do so. A friend of mine who lived
in such a community could not change the color of his front door
without his neighbors' permission.

This sounds rather like government regulation
masquerading as a private contract, but there are two important
differences. It is in the private interest of the developer to set up
the best possible rules, in order to maximize the price for which he
can sell the houses. And nobody is forced to purchase a house and
membership from that developer; if the package is not at least as
attractive as any alternative, the customer can and will go
elsewhere.

There is another private solution that applies to
the case where "You" and "I" are not two people but two
firms--merger. If a factory and a resort are both on the same
lake and the factory's pollution is ruining the resort's business,
one solution is for the two firms to join. After the resort buys out
the factory, or vice versa, the combined firm will be trying to
maximize the combined income. If controlling the factory's effluent
increases the resort's income by more than it costs the factory, it
will pay the merged firm to control the effluent. The externality is
no longer external.

One way of looking at firms is precisely as ways
of controlling such problems. As I pointed out back in Chapter 7, one
could imagine an economy of tiny firms, perhaps with only one person
in each, coordinating their activities through the market. One reason
we do not do things that way is that, when many firms are jointly
producing a single product, decisions by each one affect all the
others. If I am doing a crucial part of the job and make a mistake
that delays it for six months, I am imposing large costs on the other
firms--which I may not be able to compensate them for. By combining
all of us into one firm, that sort of externality is
internalized.

The disadvantage of doing it that way is that we
introduce a new kind of externality. Now that I am an employee
instead of an independent business, the cost of my sleeping on the
job is borne by everyone else. So a firm must monitor its employees
in ways in which it does not have to monitor other firms. The
efficient size of firm is then determined by the balance between
problems associated with coordinating a lot of small firms and
problems associated with running one large firm.

Another solution to externality problems is the
definition and enforcement of property rights in whatever is affected
by the externality. It is in one sense a governmental solution, since
property rights are defined by courts and legislatures, and in
another sense a private solution, since once property rights are
defined it is the market and not the government that decides what
happens. An example is the case of British trout streams. Trout
streams in Britain are private property. Each stream is owned by
someone--frequently the local fishing club. An industrial polluter
dumping effluent into such a stream is guilty of trespass, just as if
he dumped it on someone's lawn. If he believes the stream is more
valuable as a place to dump his effluent than as a trout stream, it
is up to him to buy it. If he believes (and the fishing club does
not) that his effluent will not hurt the trout, he can buy the stream
and then--if he is right--rent the fishing rights back to the
previous owners.

As this example suggests, what is or is not an
externality depends in part on how property rights are defined. When
I produce an automobile, I am producing something of value to you. It
is not an externality because I can control whether you get it and
will refuse to give it to you unless you pay me for it. Some
externality problems arise because property rights are not defined
when they should be: If land were not property, my fertilizing it or
planting a crop would confer positive externalities on whoever later
came by and harvested my crop. Under those circumstances, crops would
not be planted. Other problems arise because there is no way of
defining property rights that does not lead to externalities in one
direction or another. If I have to get your permission to play my
stereo when you want to sleep, I can no longer impose an externality
on you--but your decision to go to sleep when I want to play my
stereo imposes an externality on me! If only two people are involved,
they may be able to work out an efficient arrangement by mutual
negotiation--but air pollution in Los Angeles affects several million
people. Just as in the case of producing a public good, the problems
of negotiating a unanimous contract become larger the larger the
number of people involved.

One way of looking at this is to
say that all public-good/externality problems are really
transaction-cost problems. If bargaining were costless, then the
problems leading to inefficiency could always be solved. As long as
there was some change that would produce net benefits, someone could
put together a deal that would divide up the gain in such a way as to
benefit all concerned. This argument has a name--it is called the
Coase Theorem (after economist Ronald Coase). Looked at in
this way, the interesting question is always "What are the
transaction costs that prevent the efficient outcome from being
reached?"

Joint Causation, or Why Not Evacuate Los
Angeles?

Half of Coase's contribution to understanding
externalities was the observation that the problem would vanish if
bargaining between the affected parties were costless; the problem
could thus be seen as the result not of externalities but of
transaction costs. The other half was the observation that the
traditional analysis of externalities contained a fundamental
error.

So far we have followed the pre-Coasian analysis
in treating an externality as a cost imposed by one person on
another. That is not quite right. As Coase pointed out, the typical
externality is a cost jointly produced by the actions of both
parties. There would be no pollution problem in Los Angeles if there
were no pollution, but there would also be no problem, even if there
were lots of pollution, if nobody tried to live and breath in Los
Angeles.

If evacuating Los Angeles does not strike you as a
very satisfactory solution to the problem of smog, consider some more
plausible examples. The military owns bomb ranges: pieces of land
used to test bombs, artillery shells, and the like. If you happen to
be camping in one, the dropping of a three hundred pound bomb next to
your tent imposes serious externalities. It seems more natural to
solve the problem by removing the campers than by removing the
bombs.

Another example is airplane noise, which can be a
considerable problem for people who live near large airports. One
approach to the problem is to modify planes to make them quieter,
close the airport when people are asleep, and instruct pilots to
begin their descent as near the airport as possible. An alternative
is to soundproof the houses near the airport. Another alternative is
not to have anyone living near the airport: keep the land empty, use
it for a water reservoir, or fill it with noisy factories where no
one will notice the minor disturbance produced by a 747 two hundred
feet over the roof.

It is not immediately obvious which of these
alternatives provides the most efficient way of dealing with airport
noise. If we try to solve the problem by the equivalent of an
effluent fee (more generally described as a Pigouvian tax,
after A.C. Pigou, the inventor of the traditional analysis of
externalities), we may never find out. Charging the airlines for the
cost of the noise they produce give them an incentive to reduce
noise, but that may be the wrong solution--it might be less costly to
soundproof the houses or pay their occupants to move out.

The problem is that the cost is jointly produced
by the actions of both parties. If we do nothing, the cost is
entirely born by one party (the homeowners in our example) so the
other has no incentive to reduce it--even if he can do so at the
lower cost. If we impose a Pigouvian tax on the "polluter," the
"victim" may find that his best tactic is to do nothing--even if he
is the one who can solve the problem at the lower cost. If, as a
third alternative, we let the victim sue the polluter, the victim has
no incentive at all to avoid (or reduce) the cost--whatever he loses
he gets back in damage payments. Any of the alternatives might or
might not give the efficient outcome, depending on whether it happens
to impose the externality on the party who can avoid it at the lowest
cost. If the efficient solution requires actions by both
parties--soundproofing plus some noise reduction, for example--none
of the alternatives may be able to produce it.

What lessons can we learn from this depressing
tangle? The first is that the traditional analysis of externalities,
and the associated solution of Pigouvian taxes, applies only to the
special case where we already know which party is the least cost
avoider of the problem--that emission controls for automobiles in
Southern California cost less than evacuating that end of the state.
The second is that in the more general situation, where we do not
know who can solve the problem at lowest cost, the best solution may
be to fall back on Coase's other idea: negotiations between the
parties. If the airlines are liable for damage produced by noise
pollution, they may choose to pay people living near the airport to
soundproof their houses. They may even choose to buy the houses, tear
them down, and rent out the land to people who want to build noisy
factories. If the airlines are not liable for damages, it may be in
the interest of the local homeowners to offer to pay the cost of
noise reduction if that is cheaper than soundproofing. So the best
solution to such problems may be for the legal system to clearly
define who has the right to do what and then permit the affected
individuals to bargain among themselves.

In defining the initial rights--in deciding, for
instance, whether the airlines have the right to make noise or must
buy that right from the homeowners--one should consider the
transaction costs of getting from each possible definition to each
possible solution. If there are 10,000 homeowners living near the
airport, raising money to pay the airlines to keep down their noise
will be a public good for a public of 10,000; so it will almost
certainly not be produced, even if it is worth producing. If the
airlines have the right to make noise and not pay damages, they will
continue producing noise whether or not it is efficient--homeowners
will put up with the sound, soundproof, or sell out. If the airline
is permitted to make the noise but must pay damages to affected
homeowners, the airline can negotiate separately with each homeowner,
buying or soundproofing some houses and paying damages on the rest if
that is cheaper than modifying the planes--which should ultimately
lead to the efficient solution.

Suppose, as another alternative, that each
homeowner has an absolute right to be free from noise. In that case
it does the airline no good to soundproof houses or buy them unless
all 10,000 are included. The result is a holdout problem. Any
one homeowner can try to get the airline to pay him the entire
savings from soundproofing the houses instead of the planes, by
threatening to withhold his consent. With 10,000 homeowners, every
one of whom must agree, the deal is unlikely to go through--even if
it is the lowest cost solution to the problem.

In this particular case, the best solution may be
a legal rule permitting homeowners to collect damages but not to
forbid the noise. That allows whichever of the three solutions turns
out to be most efficient to occur with either no transaction (the
airline reduces its noise) or a relatively simple and inexpensive one
(the airline deals separately with the homeowners who are willing,
and pays damages to the holdouts). This solution depends, however, on
the damage done by the noise being something a court can measure. One
can imagine many cases where that would not be the case, and where a
different rule might be more likely to lead to an efficient
outcome.

Voluntary
Externalities: Sharecropping

Externalities can be eliminated by a contractual
arrangement, as when two firms merge or when I agree, in exchange for
a payment, not to do something that injures you. Externalities can
also be created by contract. One example that I will discuss a little
later is the case of insurance. By purchasing fire insurance, I
create an externality: If I am careless with matches, part of the
cost will be borne by the insurance company instead of by me. A
second example is the case of sharecropping.

Sharecropping means that a farmer pays, instead of
rent, a fixed percentage of his crop to the owner of the land he
farms. It seems an odd and inefficient arrangement. If I must pay
half of my crop to my landlord, it only pays me to make investments
of labor or capital if the payoff is at least twice the cost. I have,
by contract, created an externality of 50 percent.

This raises an obvious puzzle. Sharecropping is a
common arrangement, appearing in many different societies at
different times in history. If it is inefficient, why does it
exist?

One way of answering the question is to consider
the alternatives. There are two obvious ones. The landlord could hire
the farmer to work his land, paying him a fixed wage, or the farmer
could pay a fixed rent to the landlord and keep all of the
crop.

Converting the sharecropper into an employee is
hardly a solution; instead of collecting half the return from
additional inputs of labor he collects none of it. Switching from
sharecropping to renting may be a solution, but it has some problems.
For one thing, farm output may vary unpredictably from year to year.
If the farmer has agreed to pay a fixed rent, he does very well in
good years but may starve to death in bad ones--the rent may be more
than the full value of his crop.

Seen from this standpoint, sharecropping is, like
insurance, a device for spreading risk. The landlord and the farmer
divide the risk, instead of the farmer taking all of it. If the
random factors affect different pieces of land differently, a
landlord who owns several pieces of land can expect random effects to
average out, just as they do for an insurance company. When there is
lots of rain he gets very little from tenants farming low-lying
areas, which flood, but lots from tenants farming hilltops that are
usually too dry to grow much. Just as with insurance, the two parties
pay a price in inefficiency due to externalities in order to get a
benefit in risk spreading.

One way of reducing that price is for the landlord
to monitor the farmer--just as he would do if the farmer were an
employee. If he concludes that the farmer is not working hard enough
there is nothing the landlord can do this year, but he can find
another sharecropper next year. Sharecroppers require more monitoring
than tenants but less than employees, since they get at least part of
the output they produce.

Another explanation for sharecropping, at least in
some societies, may be that the landlord is also contributing inputs:
experience, administration, perhaps capital. If so, giving him a
fraction of the output reduces the farmer's incentive but increases
the landlord's. In this case as in many others, there may be no
efficient contract--no contract that does as well as rule by a
bureaucrat-god. Just as in choosing firm size, or controlling
externalities that are jointly caused, or picking a rule for product
liability, choosing the optimal contract involves tradeoffs among
different imperfect ways of coordinating individuals whose actions
are interdependent.

Pecuniary
Externalities

Suppose something I do imposes both positive and
negative externalities, and by some coincidence they are exactly
equal. I will, as always, treat the external costs and benefits as if
they were zero--and in this case, I will be right. Since on net all
of the costs and benefits caused by my action are borne by me, I will
make the efficient decision as to whether or not to do it.

One would think it an unlikely coincidence for
positive and negative externalities to precisely cancel; but there is
an important situation, called a pecuniary externality, in
which that is exactly what happens. Whenever I decide to produce more
or less of some good, to enter or leave some profession, to change my
consumption pattern, or in almost any other way to alter my market
behavior, one result is to slightly shift some supply or demand curve
and so to change some price; this affects all other buyers and
sellers of the good whose price has changed. In a competitive market,
the change in price due to one person's actions is tiny--but in
calculating the size of the effect, one must multiply the small
change in price by the large quantity of goods for which the price
has changed--the entire market. When, for example, I decide to become
the million and first physician, the effect of my decision in driving
down the wages of each existing physician is tiny, but it must be
multiplied by a million physicians. The product is not necessarily
negligible.

It appears that there can be no economic action
without important externalities. But these are precisely the sort of
externality that can be ignored. When price falls by a penny, what is
lost by a seller is gained by a buyer; the loss to the physicians is
a gain to their patients. The result is a pecuniary externality. My
decision to enter a profession, to buy or to sell goods, may have
more than a negligible effect on others through its effect on the
price of goods or services they buy or sell, but that effect imposes
neither net costs nor net benefits, so ignoring it does not produce
an inefficient outcome.

Religious Radio: An Application of
Public-good Theory

Whenever I spend much time listening to a variety
of stations on the radio, I am struck by how many of them are
religious. One could take this as evidence that America is a very
religious country--except that the popularity of religion on the
airwaves does not seem to be matched elsewhere. If I go to a
newsstand or a bookstore, I see relatively few religious newspapers,
magazines, or books--far fewer, as a percentage of the total, than
radio programs.

There is a simple explanation for this
discrepancy. Publishers can control who gets their publications;
broadcasters cannot control who listens to their broadcasts.
Broadcasters, unlike publishers, are producing a public good and
depend on some solution to the problem of producing a public good
privately in order to stay in business.

Commercials are one solution to that problem;
religion is another. The people who listen to religious broadcasters
presumably believe in the religion. For most of them, that means that
they believe in the existence of a god who rewards virtue and
punishes vice. If, as many radio preachers claim, donating money to
their programs is a virtuous act, then the program is no longer a
pure public good. The preacher may not know which listeners help pay
for the show and which do not, but God knows. One of the benefits
produced by the program is an increased chance of a heavenly reward;
you are more likely to get that benefit if you pay for it. Thus
religion provides a solution to the public-good problem.

Nothing in the analysis depends on whether the
particular religion is or is not true; what matters is only that the
listeners believe it is true and act accordingly. The result is that
religious broadcasters have an advantage over secular broadcasters.
Both produce programs that their listeners value, but the religious
broadcaster is better able to get the listener to pay for them. The
religious publisher has no corresponding advantage over the secular
publisher. So religion is more common on the air than in
print.

INFORMATION PROBLEMS

Long ago and far away--in Chapter 1, to be
precise--I pointed out an ambiguity in the definition of "rational."
In some contexts a rational individual was one who made the right
decision, the decision he would have made if he knew all of the
relevant facts, in other contexts a rational individual was one who
made the right decision about what facts to learn and then the best
possible decision in the context of what he knew. I suggested that
the latter definition is appropriate in situations where an essential
part of the problem is the cost of getting and using
information.

It is tempting to argue that information costs are
simply one of the costs of producing and consuming goods, and so can
be included in our analysis just like any other costs. In some
situations that argument is correct. But, as we will see in this part
of the chapter, information costs are frequently associated with
problems that lead to market failure.

Information as a Public
Good

One cost of buying goods is the cost of acquiring
information about what to buy. This may be one reason firms are as
large as they are; brand names represent a sort of informational
capital. There may be a better deal available from an unknown
producer, but the cost of determining that it is a better deal may be
greater than the savings. Not only do you know that the brand-name
product has been of good quality in the past, you also believe that
the producer has an incentive to maintain the quality so as not to
destroy the value of his brand name.

Why do we rely on brand names instead of buying
information about the quality of goods from someone who specializes
in producing such information? To some extent, we do buy information:
by reading Consumer Reports, Car and Driver, or
Handgun Tests and by taking economics courses. Yet much of the
information we use we produce for ourselves--probably a much larger
fraction than of most other things we consume. Since we do not have
the time to become experts on everything we buy, we end up depending
on brand names and other indirect (and very imperfect) ways of
evaluating quality.

Why do we produce so much information for
ourselves? Why is information a particularly hard good to produce and
sell on the market?

The problem is that it is hard to protect the
property rights of a producer of information. If I sell you a car,
you can resell it only by giving up its use yourself. If I sell you a
fact, you can both use that fact and make it available to all your
friends and neighbors. This makes it difficult for those who produce
facts to sell them for their full value. It is the same problem that
I earlier discussed in the case of computer programs--which can be
thought of as a kind of information. Information is in large part a
public good; because it is a public good, it is
underproduced.

One solution to this problem is provided by large
brand-name retailers such as Sears. Sears does not produce what it
sells, but it does select it. You may buy any particular product only
once every year or two, which makes it hard to judge which producer
is best. But you buy something from Sears much more often, so it is
easier for you to judge that Sears (or one of its competitors) "on
average" gives you good value for your money. Sears is in the
business of learning which brands of the products it buys represent
good value for the money and selling them to you under its brand
name, thus implicitly selling you the information. By not telling you
who really makes the product, it prevents you from reselling the
information--to a friend who would then buy the same brand at a
discount store. All you can tell your friend is to buy from
Sears--which is fine with Sears.

Information
Asymmetry--The Market for Lemons

Consider a situation where information is not
merely imperfect but asymmetrical. The market for used cars may be a
good example. The best way of finding out whether a car is a lemon is
to drive it for a year or two. The seller of a used car has done so;
potential buyers have not. While they can, at some cost, have the car
examined by a mechanic, that may or may not be sufficient.

Suppose, to simplify our analysis, that there are
only two kinds of cars: good cars and lemons. There are also two
kinds of people: sellers and buyers. Each seller has a car, which he
is interested in selling if he can get a reasonable price. Half have
good cars; half have lemons. Each buyer would like to buy a car--if
he can get it for a reasonable price. Sellers know what kind of car
they have; buyers do not.

Both buyers and sellers prefer good cars to
lemons. Sellers value lemons at $2,000 and good cars at $4,000--at
any price above that they are willing to sell. Buyers value lemons at
$2,500 and good cars at $5,000--at any lower price they are willing
to buy. It appears that all of the cars should sell--lemons for
between $2,000 and $2,500, good cars between $4,000 and
$5,000.

There is a problem. Buyers cannot, at a reasonable
cost, tell whether a car is a lemon. The sellers know, but have no
way of conveying the information, since it is obviously in the
interest of every seller to claim that his car is a good one. So each
buyer is buying a gamble--some probability of getting a good car and
some probability of getting a lemon.

It looks as though the probabilities are 50-50,
since half the cars are lemons. If so, and if the buyers are
risk-neutral, they will offer no more than the average of the values
of the two kinds of cars, which is $3,750. At that price, owners of
lemons will be glad to sell, but owners of good cars will
not.

The buyers can work out the logic of the preceding
paragraph for themselves. While a car offered for sale has a 50
percent chance of being good, a car that is actually sold is certain
to be a lemon, since owners of good cars will refuse the best offer
buyers are willing to make. Buyers take that fact into account, and
reduce their offers accordingly. All of the cars are worth more to
the buyers than the sellers, but only the lemons get sold. That is an
inefficient outcome. In more complicated situations, with a range of
qualities of cars, the result may be even worse; in some cases only
the single worst car gets sold.

One obvious solution is for sellers with good cars
to offer a guarantee--perhaps a guarantee to buy it back a year later
for purchase price minus a year's rental if the buyer decides the car
is a lemon. One problem with this solution is that the condition of
the car a year hence depends on a lot of things other than its
condition today, including how it is treated by its new
owner.

Adverse
Selection

The problem I have just been describing is known,
in the context of insurance markets, as adverse selection.
Consider health or life insurance. The customer has information about
himself that the insurance company cannot easily obtain: how
carefully he drives, what medical problems he has had in the past,
whether he is planning to take up hang gliding, skydiving, or
motorcycle racing in the near future. The more likely a potential
customer is to collect on his insurance the greater its value to
him--and its cost to the insurance company. If the customer knows he
is a bad risk and the insurance company does not, insurance is a good
deal--for the customer.

The good risk would be happy to buy insurance at a
price reflecting the low probability that he will get sick or die
next year, but the insurance company will not offer it to him at that
price, since the insurance company does not know he is a good risk.
The result is that bad risks are more likely to buy insurance than
good risks. Insurance companies, knowing that, must adjust their
rates accordingly--the very fact that someone buys insurance is
evidence that he is a bad risk and should therefore be charged a high
price. The higher price results in even fewer good risks buying
insurance--resulting in an even higher price. The equilibrium result
may well be that many good risks are priced out of the market, even
though there is a price at which they would be willing to buy
insurance and the insurance companies would gain by selling it to
them. Just as with automobiles, one can even construct a situation
where only the worst risks end up insured, everyone else having been
driven out of the market. Again we have an inefficient
outcome.

Insurance companies try to control this problem in
a variety of ways, including medical checkups for new customers and
provisions in insurance contracts denying payment to people who say
they have no dangerous hobbies and then die when their parachutes
fail to open two miles up. A less obvious solution is selling
insurance to groups. If all employees of a factory are covered by the
same insurance, the insurance company is getting a random assortment
of good and bad risks. The good risks get a worse deal than the bad,
but since they still get insured the insurance rates reflect the risk
of insuring an average employee rather than an average bad risk. If
insuring everyone is the efficient outcome, the group policy produces
an efficient allocation of insurance, plus a redistribution of income
from the good risks, who are paying more than their insurance costs
to produce, to the bad risks who are paying less.

One argument in favor of universal, governmentally
provided health insurance is that it is a group policy carried to its
ultimate extreme--everyone is in the group. It thus eliminates the
problem of adverse selection (except, perhaps, for people with health
problems who decide to immigrate in order to take advantage of the
program). Whether the net effect is an improvement depends on how
well the government can and does deal with other problems of
providing insurance.

Moral
Hazard

It may have occurred to you that there is another
potential inefficiency associated with insurance. Most of the things
we insure against are at least partly under our own control. That is
true not only of my health and the chance of my house burning down,
but even of losses from "acts of God" such as floods or tornadoes. I
cannot control the flood, but I can control the loss--by deciding
where to live and what precautions to take.

Whether or not I am insured, I take those
precautions, and only those precautions, that save me more than they
cost me. Once I have bought fire insurance, part of the cost of being
careless with matches and part of the benefit of installing a
sprinkler system have been transferred to the insurance company; the
cost to me is no longer the entire cost, so the result is no longer
efficient. If a sprinkler system costs $1,000 and produces a benefit
of $800 to me in reduced risk of being burned alive and another $600
to the insurance company in reduced probability of having to replace
my house, it is worth buying--but not to me.

So people who are insured will take less than the
efficient level of precaution. This problem is known as moral
hazard. It is an inefficiency resulting from an externality; once
I am insured someone else bears some of the cost of my
actions.

Insurance companies
try to control moral hazard just as they try to control adverse
selection. One way is by specifying, so far as possible, the
precautions that the insured will take--requiring a factory to
install and maintain a sprinkler system as a condition of providing
fire insurance. Another is co-insurance--insuring for only
part of the value, in order to make sure that the customer has at
least a substantial stake in preventing the risk that is insured
against. If, in my previous example, the house was insured for only
half its value, the sprinkler system would be worth more to me than
it cost, so I would buy it. If, at the opposite extreme, the
insurance company makes the mistake of insuring a building for more
than it is worth, the probability of a fire may become very high
indeed.

Warning

In thinking about market failure, it is often
tempting to interpret the problem in terms of fairness rather than
efficiency. Externalities are then seen as wrong because they are
unfair, because one person is suffering and another gaining, and
public goods as a problem because some consumers get what others pay
for.

That is a mistake. Consider the situation of a
hundred identical individuals polluting and breathing the same air.
On net there is no unfairness--everyone gains by being able to
pollute and loses by being polluted. Yet because each person bears
only 1 percent of his pollution, each pollutes at far above the
efficient level and all are, as a result, worse off. This is
precisely analogous to the effect of the potato subsidy discussed in
Chapter 3; everyone gets back in subsidy as much as he pays in taxes
yet ends up worse off, not because he is poorer but because he is
buying too many potatoes.

The same is true for the other kinds of market
failure. The ultimate problem with public goods is not that one
person pays for what someone else gets but that nobody pays and
nobody gets, even though the good is worth more than it would cost to
produce. The major cost of adverse selection is not that some people
buy lemons or write life insurance policies on skydivers. The major
cost is that cars are not sold, even though they are worth selling,
and people do not get insured, even though they are worth
insuring.

PROBLEMS

1. Describe two public-good problems that you have
yourself observed and in some way been involved with in the past year
and discuss how they might be dealt with; you should not use any that
are discussed in the chapter.

2. In ordinary markets, supply and demand are
balanced by price. Given that our customs prohibit, in most social
contexts, cash payments as part of a date (or a marriage), what sorts
of "prices" balance those markets in the United States at present? If
supply and demand on the dating/sex/marriage market are not balanced
(quantity supplied is not equal to quantity demanded: more men want
to go out or have sex or get married than women, or vice versa), what
mechanisms ration out the insufficient supply (decide which men get
women, or vice versa)? What prices balance supply and demand for
similar markets in other countries or have done so at other
times?

3. How would the style of dating and marriage
change if a war substantially reduced the ratio of men to women? How
would it change if a lot of men migrated to the United States,
substantially raising the ratio of men to women?

4. "Heterosexual men are traditionally hostile to
homosexual men. If they correctly considered their own interests,
their attitude would be just the opposite." Discuss.

5. "The public-good problem is both an argument
for government intervention in the market and an argument against
government intervention in the market." Explain.

6. Students frequently argue that grades should be
deemphasized or abolished. The same students start the first class of
the quarter by asking me about my grading policy--and continue
throughout the course to exhibit a keen interest in what will or will
not be on the final exam. Is their behavior inconsistent?

7. A tape recorder can copy a recording of a
concert onto a cassette just as a computer can copy a program onto a
disk. Why is the problem of pirating (making copies without paying
royalties) less serious in the case of tapes than in the case of
programs?

8. In my experience, FM radio is less religious
than AM; you may wish to check that conclusion for yourself. Can you
suggest any reasons why? (I am not sure I know the answer to this
one.)

9. Last year Bryan and Brian occupied separate
apartments; each consumed 400 gallons per month of hot water. This
year they are sharing a larger apartment. To their surprise, they
find they are consuming 1,000 gallons per month. Explain.

10. One of my students cannot possibly take the
midterm at the scheduled time. I am afraid that if I give it to him
early, he might talk about it to other students, giving them an
unfair advantage, and that if I give it to him late, other students
might talk to him about it, giving him an unfair advantage. Given the
problems associated with property in information, which problem do
you think is more likely to arise? Discuss. Does it depend on whether
the students believe that I grade on a curve?

11. The following table shows, for three different
goods (produced by three different firms), total cost of production
(as a function of quantity produced), total external cost imposed by
producing the goods, and their total value to the consumer. Assume
the manufacturer can sell the goods at their value, which is the same
for all three goods ($10/unit). He must pay the cost of production
but does not have to pay for the external cost. Fractional units
cannot be produced; output can be 0,1,2,3, ... but not 2
1/2.

a. How much does each firm choose to
produce?

b. In which, if any, cases is the outcome
efficient?

c. In the inefficient cases, how large would the
net gainbe if the firm was forced to produce the efficient
level of output instead of the profit-maximizing level?

Lamps

Books

Pies

# of Units

Production Cost

External Cost

Production Cost

External Cost

Production Cost

External Cost

Value

1

$6.00

$0.50

$9.00

$2.00

$8.00

$1.00

$10.00

2

$14.00

$1.00

$18.00

$3.00

$16.00

$2.00

$20.00

3

$25.00

$1.50

$27.00

$4.00

$25.50

$3.00

$30.00

4

$39.00

$2.00

$39.00

$5.00

$36.00

$4.00

$40.00

12. " . . . another reason to contribute to our
fund-raising campaign is self-interest. The money you give us will
improve the quality and reputation of the University, raising the
value of your degree. If each alumnus gave $100 . . ." (extract from
a fund-raising letter). What is wrong with this argument? Why is it
unlikely to succeed?

13. While visiting one of the publishers that
wanted to publish this book, I raised the question of whether the
book should be published with or without color figures. Using color
makes a book more attractive but more expensive to produce. I was
told that they preferred to decide such matters at a later stage in
the process of producing the book.

a. Why do you think they do it that
way?

b. What conclusions do you think I drew about the
publisher? Do you think they ended up publishing the book?
Explain.

Hint: An author's royalties are usually a fixed
fraction of revenue; the publisher recieves the rest, and pays all
expenses of producing and selling the book.

14. Many of the efficiency problems discussed in
previous chapters could be described in terms of externalities; give
three examples, with brief explanations of each.

FOR FURTHER READING

Carlo M. Cipolla, Money, Prices, and
Civilization in the Mediterranean World (Staten Island, NY:
Gordian Press, 1967). This book contains a number of interesting
essays on the economics of the past, including an interesting
discussion of barter in the Middle Ages.

The Coase Theorem first appeared in Ronald Coase,
"The Problem of Social Cost," Journal of Law and Economics,
Vol. 3 (1960), pp. 1-44.